Mortgage diamond clamps down on ARMs, IOs

The Danish FSA (Finanstilsynet) set out proposals for a “Supervisory Diamond” for Denmark’s mortgage credit institutions on Thursday of last week (11 September) that aims to reinforce the Danish industry’s systemic stability, including moves away from one year ARMs and interest-only (IO) loans.

The rules have been in the works since last year and were initiated after after the publication in September 2013 of a Danish report into the financial crisis. The Supervisory Diamond will be established alongside a separate framework that has been in force for the countries’ universal banks.

The rules, according to the wording of an English language Finanstilsynet document, are:

• Large exposures: The sum of the 20 largest exposures > CET1
• Lending growth: Lending growth to each lending segment < 15% per year (The lending segments are: private homeowners, property rental, agriculture and other corporate)
• Interest rate risk of the borrower: Lending where the LTV exceeds 75% of the lending limit for MCIs (mortgage credit institutions) and an interest rate fixed less than 2 years < 30% (Applies only to private homeowners and property rental)
• Interest only lending: The share of interest-only lending (no amortisation) < 55% of total lending in the LTV band above 75% of the lending limit for MCIs (Applies only to private homeowners)
• Short term funding: The share of lending with semi-annual refinancing < 15% of total lending

The FSA said that the short term funding and interest only initiatives will only apply from 2020, in order to give MCIs time to adjust, while the others will apply from 2018.

Finanstilsynet announced two other measures, which it said counter risks of the future development of real estate bubbles. It said they are consistent with present standards in the banking sector but will ensure that these are not lowered in the future.These are:

• At least 5% own financing by the borrower when lending to private homeowners. Applies to both mortgage institutions and credit institutions. Possibility not to apply in special circumstances if sufficiently prudent.
• When lending to property rental there shall be a positive liquidity in the property. Applies only to credit institutions. Special rules for real estate development will apply.

“The Supervisory Diamond is an important step in ensuring a strong Danish mortgage credit sector in the future,” said the FSA. “The mortgage credit institutions have already taken several steps in the right direction. The Supervisory Diamond now sets a framework for the long run adjustment.”

According to Christina Falch, senior analyst at Danske Bank, the rules are in line with what had been expected after a leak during the summer, but with an important difference being the introduction of a limit on the proportion of IO loans to borrowers with an LTV above 60%.

“Our general assessment is that the coming Supervisory Diamond will prompt the mortgage credit institutions to maintain their focus on reducing the proportion of interest-only loans and loans with annual refinancing and on spreading out the auctions,” she said.

“However, this process is already under way, as the MCIs have in recent years been encouraging borrowers to opt for repayment mortgages and fixed-rate loans or ARM loans with a longer period between refinancing, for example by changing their loan cost structures.”

Ane Arnth Jensen, managing director at the Association of Danish Mortgage Banks (Realkreditrådet) said that the framework reflects developments already underway in the Danish mortgage banking sector.

“Our perspective on the way that it has turned out is that we support the objectives of securing financial stability,” she said. “The mortgage banks have already taken a lot of actions that are aligned with the intensions of the Supervisory Diamond, and it is only natural that these rules are now put in writing.”

Jensen cited as example the way in which Danish issuers have spread out through the year auctions for bonds refinancing adjustable rate mortgages (ARMs).

“They have had quite a successful outcome,” she said. Given an 80% limit on LTVs in Denmark, the 75% figure in the IO limit with regard to private homeowners equates to 60% LTVs.

Jensen said that the target of 55% looks manageable, given mortgage trends and the volumes outstanding. According to Jensen, IOs account for 55% of new loan production, while their share of the stock of mortgage loans outstanding is 65%. She estimated that some Dkr25bn-Dkr30bn (Eu3.4bn-Eu4bn) of loans will therefore need to be converted to amortising loans.

“Is that difficult? That’s hard to answer,” she said. “But the average maturity of mortgage loans right now is seven to eight years, and so a lot of Danish loans will be renewed by then, so there is the possibility that if current behaviour is continued that will contribute a large part of the change that is necessary.

“You have to bear in mind that mortgages are long term loans,” she added, “so it is not easy to change from one day to the next and you have to be patient.”

Jensen noted that comparable rules regarding IO loans for home equity-style loans will also be applied to the rules for Danish universal banks, meaning that a level playing field between the two types of banks will be ensured.

A public consultation on the proposals will run until 8 October.

Photo: Lennart Søgård-Høyer